The National Flood Insurance Program (NFIP) is the primary underwriter of flood insurance policies in the United States. The program was established in 1968 through the passage of the National Flood Insurance Act.
Since its formation, the NFIP has never utilized any financial risk transfer mechanism. Rather, it has relied on the US Treasury to fund deficits when event losses exceeded its net premium balance. From the mid-1980s until Hurricane Katrina in 2005 the NFIP was financially self-supportive. Despite years that produced deficits and required borrowing to respond to claims, the NFIP managed to repay the loans with interest.
Hurricane Katrina in 2005 was a seminal event that produced over USD16 billion of losses to the NFIP, which together with Hurricanes Rita and Wilma, produced a deficit of over USD17 billion at the end of 2005. As part of the Biggert- Waters Act, which reauthorized the NFIP in 2012, Congress tasked Federal Emergency Management Agency (FEMA) with addressing the financial shortfalls of the program. In late 2012 the NFIP’s deficit position was further exacerbated by Hurricane/Tropical Storm Sandy - expanding the NFIP deficit to the US Treasury to USD24 billion.
Legislation mandated the Flood Insurance Risk Study (FIRS). The project sought support to evaluate the potential means by which the NFIP might privatize either fully or partially, how the NFIP might utilize reinsurance to support its risk management processes and how the NFIP’s claims-paying ability would evolve under certain economic scenarios as the program implemented change. Guy Carpenter, acting as the lead contractor, brought together a consortium of companies including Oliver Wyman and Marsh, sister companies of Guy Carpenter, as well as third-party partner companies AIR Worldwide and JBA Consulting to respond to FEMA’s request for proposals.
The major themes of the response included the following:
- Privatization Study: An analysis of the private sector’s capacity and appetite to provide flood insurance found that greater private sector involvement would promote innovation through market competition potentially leading to improved product offerings, lower prices for consumers and greater flood insurance penetration. It would also reduce the government’s direct flood risk exposure and create new product demand for (re)insurers and the capital markets.
- Reinsurance Study: As demonstrated by the US residual market facilities and other international catastrophe-exposed government sponsored facilities that utilize reinsurance, reinsurance can complement the risk financing structure of the NFIP. A combination of insurance and reinsurance, including insurance-linked securities risk-transfer facilities, should be employed by the NFIP to reduce and manage its risks.
Though there are many potential benefits to a private market for flood insurance, the transition is clearly not without obstacles. Today, catastrophic loss potential and insufficient insurance premiums to cover the losses remain paramount concerns. Historically, private insurers chose not to underwrite flood risk because it was difficult to measure and quantify and subsequently difficult to price adequately, with the potential for extreme losses.
A major challenge for the NFIP is risk-based rating. Insurers need to have the freedom to rate and sell products at appropriate prices. There is a need for higher NFIP rates, obvious because of its deficit, in order to promote private sector engagement. To strengthen flood insurance finances in the United States risk weighted rates are needed, which ideally would equate to risk-based rates. If this cannot be achieved then other mechanisms for filling the gap should be studied. For example, in the United Kingdom, levies will be used to help finance sustainable flood insurance - those less exposed pay less, but everyone contributes. In the United States some have suggested “means-tested” vouchers to help those unable to afford their flood premiums. These and other tools should be employed provided they support and are consistent with a long-range plan to construct sustainable solutions to flood risk financing.